Money Laundering Concerns in Islamic Financial Transactions

While the world is becoming more integrated with all its crises, problems and merits, nothing can be outside the scope of global integration in terms of financial markets. Compared to previous decades, financial system conversion is much more comprehensive regarding developments in information technologies and transportation. However, no income is earned without a cost. Inherited risks of the financial system do not disappear, but evolve. Money laundering is just one important aspect of the current global financial system, which affects Islamic financial business.

As defined by the Financial Action Task Force (FATF), money laundering occurs when criminals possess an amount of money and try to disguise its illegal origin. They want to penetrate into the financial system and try to erase all tracks that may point to them or suggest illicit funds.

As money laundering is harmful both for society and the entire financial system, as well as for global security since the methods are only limited to individuals’ creativity, compliance with global best standards and practices must be improved yearly. In this broad environment, Islamic financial business arises with its idiosyncratic transaction methods.

Whereas Islamic finance is much more risk-oriented compared to conventional practices, it also needs an enhanced governance environment for Islamic finance players because adverse findings not only affect the institution but also affect the overall sector. Therefore anti-money laundering issues should be carefully planned and implemented in Islamic finance institutions.

In terms of the Shariah, money laundering is prohibited due to its harmful effects to society, unjust earnings (haram) from illicit activities and its promotion of corruption. According to Islam, socio-economic justice is important not only as a governmental policy, but also among individuals. The reason for this is that the wealth given to an individual is seen as a gift from God, but the individual is not the ultimate owner of this wealth, since (s)he is required to spend some of the wealth for the prosperity and happiness of the society overall. Thus, society and other individuals also have a right to the wealth. Illicit gains acquired by criminal activity, therefore, affect the best interests of the public by causing unjust income distribution, misbalancing prices of assets and commodities and misallocating resources by encouraging more crime and corruption.

Another point is that the resources of the illicit funds are mostly unlawful and/or criminal offences, which are also cited as Haram under Islamic laws. Even purification with donation (Zakat) does not give any merit to the possessor of these funds. So there is a great responsibility for Islamic financial institutions to avoid the co-mingling of ‘good’ money (Halal) with ‘bad’ money (Haram) due to the impractical difficulties of separation in their pools of funds. If Haram funds are mixed with Halal, th institutions will also have failed in their duty towards their customers, who have invested in these institutions with good faith.

As the FATF is planning to cite tax evasion as a predicate offence of money laundering, this issue will also be revealed as a point of concern in terms of Shariah. A common practice for tax evasion is to try and conceal information related to funds or assets by having several offshore accounts and establishments in relevant tax haven jurisdictions. Without any prejudices, the funds belong to an ultimate beneficiary whose main aim is to keep his tax burden as low as possible.

In terms of Islamic principles, this is also a concern because a government has an obligation to provide basic services to its citizens like education, health and charity in consideration of tax payments, which are regulated by law.

So an Islamic financial institution should think twice about these kinds of funds in terms of Shariah compliance. What would the proper course of action be, should it was made aware of the truth of tax evasion? It is also a fact that under Shariah, the legality (or illegality) of a contract or transaction is determined by the intention of the contract or transaction itself. There may be well-established documentation and establishment under a strong jurisdiction to conceal ultimate beneficiary or funds’ resource. However, if intentions are different than the underlying contract/transaction, then the overall process will also be non-compliant.

Without any doubt, the main concerned Islamic finance product is the Hawala, where either money is carried individually from one location to another; or transferred via known Hawaladars, who are Hawala brokers. The first scheme has almost disappeared due to high counter terrorist financing standards in most countries. However, the latter is still common, especially in the eastern hemisphere. Since there are no written instruments, electronic transfer orders, account numbers or legally binding agreements, the system depends on the individual honor system and there is no any audit trails for funds.

Another concern with this system is its potential harm to free market conduct. Since market brokers are not supposed to apply official exchange rates, they also bypass the free market rates of source and recipient currencies, which create a sum of money that should affect the recipient country’s foreign exchange rates but is actually not recorded.

Due to differences in legislation and the lack of a well-regulated banking system, some countries use Hawala for the requirements of their financial system. As is clear, the system is very basic and far removed from any kind of government regulation and/or control as well as tracking.

Recently, the Hawala system has created great concerns for western society following some worrying findings from governments and supranational organizations: such as the asset freeze of a famous Somalian Hawala brokerage company after the September 2011 attacks, or the use of a licensed Hawala broker for the transfer of opium payments in Afghanistan. This may not be an issue where Hawaladars are well regulated and have some kind of license for their brokerage activity, but for many countries Hawala continues to be a primary method of money laundering.

Another concern comes with the process known as ‘purification’. This process is the voluntary donation of capital gains which are non-compliant in terms of Shariah. Although Shariah scholars have different opinions, this is usually a percentage of the capital gains that have attracted (or are assumed to attract) some non-compliant parts of the relevant asset, e.g., interest-bearing finance costs, dividends paid, etc.

Shariah compliant institutions are required to donate these funds for purification. However, the concern arises here: to where should they donate? There is no problem in donating funds to well-known government charities, but if the institution chooses other kinds of charities or donation recipients which are not regulated by public bodies and/or are not licensed, a potential money laundering risk arises as charitable organizations are one of the most common types of money laundering transactions. In order to mitigate this risk, organizations should maintain a ‘conflict of interest’ policy to prevent donations to associated organizations and conduct due diligence for those organizations.

Shariah compliant financing options may also create an exposure to money laundering. Islamic financial institutions have other counterparties in trade finance business because the disbursement to the immediate beneficiary of the loan is prohibited under Shariah. However, institutions which fail to include the third party in their client due diligence practices may cause use of illicit use of funds. This approach, as well as offering the risk of laundering, places an additional burden on Islamic financial institutions compared to conventional financial institutions.

Firms which aim to carry out Shariah compliant business are also faced with the burden of additional client due diligence processes. All parties involved in a Musharakah transaction should be disclosed in full. This is not only a requirement under our contemporary laws and regulations, but also a requirement under Shariah. Although Muslims are required not to spy on others’ faults, there are some exceptions in Shariah which encourage people to disclose and warn others, especially when the public’s best interest is about to be distorted.

Islamic finance has created an opportunity for financial markets in terms of low risk products and services for best interests of society. It has also paved the way for the integration of idle funds into the financial markets. However, its unique risks and transaction systems should be thoroughly analyzed to prevent non-compliant transactions (from both a legal and Shariah perspective) and to inhibit the practice of money laundering.